ENGG 401 X2
Fundamentals of Engineering Management
Spring 2008
Chapter 3 (cont):
Depreciation
Dave Ludwick
Dept. of Mechanical Engineering
University of Alberta
http://members.shaw.ca/dave_ludwick/
ENGG 401 X2 – Fundamentals of Engineering Management
Discussion Question #1
• Think about how many hours per year each of the following
pieces of equipment operates.
– pump in an oil refinery
– telephone switch
– family automobile
– lawnmower
• How many hours in the total life of the piece of equipment?
Dave Ludwick, Dept. of Mech. Eng.
Depreciation
2 Summer 2008
ENGG 401 X2 – Fundamentals of Engineering Management
Discussion Question #2
• Two brothers inherit $1 million each. The conservative
brother buys a 20 year bond yielding 5.5% and hence
makes $55,000 per year. The entrepreneurial brother buys
two oil well service rigs, and makes $70,000 a year in cash
from the business. 15 years later, over a beer, the
entrepreneurial brother brags that he made the better
choice. Assuming the entrepreneurial brother didn’t work in
the service rig business (i.e., he had another job), was he
right? Why?
Dave Ludwick, Dept. of Mech. Eng.
Depreciation
3 Summer 2008
ENGG 401 X2 – Fundamentals of Engineering Management
Capital Assets
• Capital Assets – assets used in the operations of a
company and have a useful life of more than one
accounting period
• Generally divided into 2 groups
– Tangible Assets – Property, Plant and Equipment
– Intangible Assets – patents, copyrights, trademarks (excluding
goodwill)
• The three major accounting issues to examine are
– The accounting for initial and subsequent costs
– Allocating costs of capital assets against revenues
– Recording the disposal of the capital assets
Dave Ludwick, Dept. of Mech. Eng.
Depreciation
4 Summer 2008
ENGG 401 X2 – Fundamentals of Engineering Management
Costs of Capital Assets
• Capital assets are recorded at cost, which includes normal
and reasonable expenditures to get the asset to a place
where it can be useful
– Freight, packing and unpacking costs, installation costs, non-
refundable taxes
– These are known as capital expenditures
• Capital Expenditures are costs relating to capital assets that
provide a benefit beyond the current period.
– They are added to the capital assets line and depreciated along with
the capital assets over time.
Dave Ludwick, Dept. of Mech. Eng.
Depreciation
5 Summer 2008
ENGG 401 X2 – Fundamentals of Engineering Management
Land
• Land is a special asset. It can’t be depreciated.
– But stuff on the land, like buildings, parking lots, etc are depreciated.
• Cost of land will include its price, real estate commissions,
insurance for titles, legal fees and accrued property taxes
• Costs relating to land preparation for building are also
added to the cost of the land
• Costs relating to removing old unwanted buildings or scrap
can also be added to the land. If those are sold for salvage,
then the salvage amount is subtracted from the land costs
Dave Ludwick, Dept. of Mech. Eng.
Depreciation
6 Summer 2008
ENGG 401 X2 – Fundamentals of Engineering Management
Buildings
• Building costs include its purchase price, commissions,
taxes, legal and title fees. These are all costs needed to
make the building ready for use.
• Buildings are depreciated over a defined useful life
Dave Ludwick, Dept. of Mech. Eng.
Depreciation
7 Summer 2008
ENGG 401 X2 – Fundamentals of Engineering Management
Amortization and Depreciation
• Capital Assets wear out over time or decline in usefulness
• Amortization or depreciation is the process of matching or
allocating the cost of the capital assets over the time that
the asset is used.
– In effect, accounting is trying to use the matching principle to match
the cost of the assets to the revenues they helped create.
• We only start recording asset depreciation once the asset is
put into use
• We often use the words Depreciation and Amortization
inter-changeably
– We usually depreciate fixed assets
– We usually amortize intangible assets
– But, it is okay to use them inter-changeably because they mean the
same thing
Dave Ludwick, Dept. of Mech. Eng.
Depreciation
8 Summer 2008
ENGG 401 X2 – Fundamentals of Engineering Management
Depreciation
• Depreciation is a charge against earnings to reflect the
need to replace wearing out of assets.
• Depreciation is not a cash cost.
– The business has already spent the cash.
– It can be thought of as a recovery of previously spent costs (or “pre-
recovering” future costs).
– If these costs can not be recovered, then the business isn’t earning
its cash flow.
• Note that depreciation is a process of cost allocation NOT
asset valuation.
– Amortization is not a measure of an assets declining market value
Dave Ludwick, Dept. of Mech. Eng.
Depreciation
9 Summer 2008
ENGG 401 X2 – Fundamentals of Engineering Management
Depreciation (2)
• Assets last longer than a single year.
• All assets that wear out flow through the income statement
as an expense.
• This expense is either
– Depreciation, normal loss of value, over time, or
– A writedown, the remaining book value of the asset when it is taken
out of service.
• Accumulated Depreciation
– the sum total of all the depreciation taken to date
– Depreciation Expense, Yr 1 + Depreciation Expense, Yr 2 + …
Depreciation Expense, Yr N
Dave Ludwick, Dept. of Mech. Eng.
Depreciation
10 Summer 2008
ENGG 401 X2 – Fundamentals of Engineering Management
Depreciation (3)
• We should make reasonable efforts to estimate the “correct”
period for replacement.
– Too short a period depresses earnings, and makes the business
look like an underperformer during the depreciation period, with a
sudden swing up in earnings at the end of the period. Which would a
buyer believe?
– Too long a period overstates earnings but requires a writedown of
residual value at the time of replacement, since the equipment is not
fully depreciated. Writedowns are a potential problem at time of sale.
Dave Ludwick, Dept. of Mech. Eng.
Depreciation
11 Summer 2008
ENGG 401 X2 – Fundamentals of Engineering Management
Calculating Depreciation – Terms for reference
• Cost – the cost of the capital asset including all reasonable
costs needed to acquire it and prepare it for use
• Salvage Value – aka Residual Value, is an estimate of the
amount that the asset could be sold for at the end of its
useful life
• Useful Life – aka Serviceable Life, the length of time over
which the asset is productive
– Different types of assets will have different useful lives
• There are many ways to calculate depreciation which we
will see in a few minutes
Dave Ludwick, Dept. of Mech. Eng.
Depreciation
12 Summer 2008
ENGG 401 X2 – Fundamentals of Engineering Management
Writedowns
• A writedown is when we reduce the book value of an asset
by a decision of management (or by circumstances that
arise).
• If the depreciation period of an asset is longer than its
actual lifetime, the remaining undepreciated value of the
asset charged as an expense (a writedown).
– Operating income is overstated during the depreciation period.
– Usually listed with the “other income” category as an extraordinary
one-time expense.
– Often lists a few words to clarify it as well:
• “loss on sale of assets”, “disposal of assets”, “liquidation of assets”,…
Dave Ludwick, Dept. of Mech. Eng.
Depreciation
13 Summer 2008
ENGG 401 X2 – Fundamentals of Engineering Management
Gain on Sale of Assets
• The opposite of a writedown can also occur, and is
considered to be a gain on the sale of assets.
• If the depreciation period is shorter than the actual life of the
asset, the market value of the asset is more than the “book
value”.
– Operating income is depressed during the depreciation period and
“bumps up” at the end of the depreciation period.
• If the asset is sold for more than its book value, the gain is
also listed as “other income” on the income statement.
– Often lists a few words to clarify it as well:
• “gain on sale of assets”, “disposal of assets”, “liquidation of assets”,…
Dave Ludwick, Dept. of Mech. Eng.
Depreciation
14 Summer 2008
ENGG 401 X2 – Fundamentals of Engineering Management
Calculating Depreciation
• There are four different methods of calculating depreciation:
– Straight line is the most common and the easiest to work with in
interpreting year over year results.
• The danger is that in early years, the “book value” may be significantly
higher than its resale value.
– Sum-of-the-years digits depreciates more heavily in earlier years.
• It more accurately reflects resale value.
– Declining balance depreciation is also more heavily weighted to
earlier years of an asset’s life.
• The motive is often economic stimulation.
• Income tax uses this method.
– Units-of-production depreciation recovers costs based on the use
of the asset rather than time (age).
Dave Ludwick, Dept. of Mech. Eng.
Depreciation
15 Summer 2008
ENGG 401 X2 – Fundamentals of Engineering Management
Straight Line Depreciation
• The simplest depreciation method is straight line
depreciation where an asset’s value is depreciated at a
constant rate over it’s lifetime.
– The annual depreciation charge is the same in each year.
• Straight line depreciation:
– Depreciation Expense =
• (Total Cost – Salvage Value)/No. useful periods
• Where, the No. of useful periods is the life of the asset in terms of the
number of accounting periods (ex: number of quarters if the statements
are being prepared quarterly)
Dave Ludwick, Dept. of Mech. Eng.
Depreciation
16 Summer 2008
ENGG 401 X2 – Fundamentals of Engineering Management
Straight Line Depreciation Example
• In April, you purchase a patent for $6800 and depreciate its
value using the straight line method over 17 years, after
which you expect it to have no value. Calculate the patent’s
annual depreciation charge and remaining value each year.
– Depreciation Expense =
• (Total Cost – Salvage Value)/No. useful periods
• (6800 – 0) / 17 = 400 per year
• Note: We have special rules for handling the first year of
depreciation
Dave Ludwick, Dept. of Mech. Eng.
Depreciation
17 Summer 2008
ENGG 401 X2 – Fundamentals of Engineering Management
Partial-Year Depreciation
• Assets are not always acquired at the beginning of a period
• To account for this, there are 2 ways to calculate the first
year’s depreciation expense
• Nearest Whole Month
– If the asset is purchased in the first part of a month, that whole
month and all months after it until the end of the period are
considered the first year
– Example: A patent is purchased for $6800 on April 8, with a fiscal
year end of Dec 31 and salvage value of $0 in 17 years
– First Year Depreciation = [(Cost – Salvage Value)/Estimate useful
life]* 9/12
Dave Ludwick, Dept. of Mech. Eng.
Depreciation
18 Summer 2008
ENGG 401 X2 – Fundamentals of Engineering Management
Partial-Year Depreciation
• Half-Year Rule
– The materiality principal may allow a company to simply use the half
year rule for the first year’s depreciation amount
– The Half-Year Rule says the regardless of when the asset was
purchased, only half of the depreciation is allocated in the first year.
– The process is to calculate what normally would be the first year’s
depreciation, then multiply it by half.
• This applies to all the depreciation calculation methods except Units of
Production
• Each of these rules would be used for all of the depreciation
methods except Units-of-production
Dave Ludwick, Dept. of Mech. Eng.
Depreciation
19 Summer 2008
ENGG 401 X2 – Fundamentals of Engineering Management
Straight Line Depreciation In-Class Problem
• You purchase a new $9000 asset on February 23 and
decide to calculate its depreciation using the straight line
method over a period of five (5) years, after which you
expect to be able to sell it for $700. The company’s fiscal
year end is December 31.
• Calculate the asset's annual depreciation charge and its
remaining value each year. For the first year, use the
nearest whole month rule.
Dave Ludwick, Dept. of Mech. Eng.
Depreciation
20 Summer 2008
ENGG 401 X2 – Fundamentals of Engineering Management
Sum-of-the-Years’-Digits Depreciation
• The sum-of-the-years’-digits depreciation method is a
more accurate model for some assets (e.g., car) whose
value depreciates more in the earlier years of its life.
• Sum-of-the-years’-digits depreciation expense:
N  t 1
dt   B  S 
SOYD
– t = period number
– dt = depreciation expense in year t
– B = original value of asset (cost basis)
– N = depreciable lifetime, in years
– S = expected salvage value of asset after depreciable lifetime
– SOYD = sum of the years’ digits = N(N+1)/2
Dave Ludwick, Dept. of Mech. Eng.
Depreciation
21 Summer 2008
ENGG 401 X2 – Fundamentals of Engineering Management
Sum-of-the-Years’-Digits Example
• You purchase a new asset for $5000 and expect to sell it for
$1000 after 4 years. Calculate the sum-of-the-years’-digits
depreciation charges and book value for each year.
N  t 1
dt   B  S 
SOYD
4  1 1
d1    $5000  $1000   $1600 BV1  $5000  $1600  $3400
1 2  3  4
4  2 1
d2    $5000  $1000  $1200 BV2  $3400  $1200  $2200
1 2  3  4
4  3 1
d3    $5000  $1000  $800 BV3  $2200  $800  $1400
1 2  3  4
4  4 1
d1    $5000  $1000  $400 BV4  $1400  $400  $1000
1 2  3  4
Dave Ludwick, Dept. of Mech. Eng.
Depreciation
22 Summer 2008
ENGG 401 X2 – Fundamentals of Engineering Management
Sum-of-the-Years’-Digits In-Class Problem #1
• You purchase a new $9000 asset on February 23 and
decide to calculate its depreciation using the sum-of-the-
years’ digits method over a period of five (5) years, after
which you expect to be able to sell it for $700. The
company’s fiscal year end is December 31.
• Calculate the asset's annual depreciation charge and its
remaining value each year.
Dave Ludwick, Dept. of Mech. Eng.
Depreciation
23 Summer 2008
ENGG 401 X2 – Fundamentals of Engineering Management
Sum-of-the-Years’-Digits In-Class Problem #2
• You purchase a new $900 asset in April and decide to
calculate its depreciation using the sum-of-the-years’ digits
method over a period of five (5) years, after which you
expect to be able to sell it for $70.
• Calculate the asset's annual depreciation charge and its
remaining value each year.
Dave Ludwick, Dept. of Mech. Eng.
Depreciation
24 Summer 2008
ENGG 401 X2 – Fundamentals of Engineering Management
Depreciation Methods
• Declining-balance Method
– This is an accelerated depreciation method: It allocates
comparatively more to depreciation expense in early years and
smaller amounts in later years
• The rate of the acceleration can be different for each asset (but must be
consistent over the life of that asset)
• The amount of depreciation expense applied is based on the book value
in that period.
– This methods attempts to more closely approximate the value of the
asset over its life
Dave Ludwick, Dept. of Mech. Eng.
Depreciation
25 Summer 2008
ENGG 401 X2 – Fundamentals of Engineering Management
Depreciation Methods
• Declining-balance Method
– Two Step Process
• Calculate the declining balance rate
• Calculate the depreciation expense by multiplying the rate by the asset’s
beginning of period book value.
– Details
• Example using Double-declining balance (where “double” means X=2)
• Step 1: Rate = X/Estimated Useful Life = 2/Estimated Useful Life
• Step 2: First year Deprec. Exp. = Rate * Beg. Period Book Value
• Step 3:
– Next year Beg. Balance = Previous year beg balance – Deprec. Exp.
• Notice how the Beg. Period book value is the previous period’s end of
period book value
• Triple-declining balance, X=3, quadruple, X=4, etc
• Your book uses another method which also works
Dave Ludwick, Dept. of Mech. Eng.
Depreciation
26 Summer 2008
ENGG 401 X2 – Fundamentals of Engineering Management
Declining Balance Depreciation Problem #1
• You purchase a new $900 asset and decide to calculate its
depreciation using the declining balance method with a
depreciation rate of 40% over a period of five (5) years.
• Calculate the asset's annual depreciation charge and its
remaining value each year.
Dave Ludwick, Dept. of Mech. Eng.
Depreciation
27 Summer 2008
ENGG 401 X2 – Fundamentals of Engineering Management
Declining Balance vs. Straight Line Depreciation
$1,200.00
$1,000.00
$800.00
Book Value
Declining Balance Depreciation
$600.00
$400.00
$200.00 Straight Line Depreciation
$-
0 2 4 6 8 10
Year
Dave Ludwick, Dept. of Mech. Eng.
Depreciation
28 Summer 2008
ENGG 401 X2 – Fundamentals of Engineering Management
Double Declining Balance Depreciation
• The double declining balance depreciation (DDB)
method is a special case of declining balance depreciation,
where the rate of depreciation is double the straight line
depreciation rate.
– i.e., straight line depreciation is 1/N of the original value (minus
salvage value) per year, while the double declining balance rate is
2/N of the current book value per year.
• Historically, companies most often used either the straight
line method or the double declining balance method
Dave Ludwick, Dept. of Mech. Eng.
Depreciation
29 Summer 2008
ENGG 401 X2 – Fundamentals of Engineering Management
Declining Balance Depreciation Problem #2
• You purchase an asset for $10 000 and decide to calculate
its depreciation using the double declining balance
method over a period of ten (10) years, after which you
expect it to have a salvage value of $1000.
• Calculate the asset's annual depreciation charge and its
remaining value each year.
Dave Ludwick, Dept. of Mech. Eng.
Depreciation
30 Summer 2008
ENGG 401 X2 – Fundamentals of Engineering Management
Declining Balance Depreciation Problem #3
• A constraint with the declining balance depreciation method
is that the accumulated depreciation cannot exceed the
purchase cost less the salvage value (i.e., it’s book value
cannot drop below it’s salvage value).
• What if the asset in the previous example would have a
salvage value of $3000 instead of $1000?
Dave Ludwick, Dept. of Mech. Eng.
Depreciation
31 Summer 2008
ENGG 401 X2 – Fundamentals of Engineering Management
Double Declining Balance vs. Straight Line (2)
$1,200.00
$1,000.00
$800.00 Straight Line Depreciation
Book Value
$600.00
$400.00
$200.00
Double Declining Balance Depreciation
$-
0 2 4 6 8 10
Year
Dave Ludwick, Dept. of Mech. Eng.
Depreciation
32 Summer 2008
ENGG 401 X2 – Fundamentals of Engineering Management
Units-of-Production Depreciation
• The units-of-production depreciation method is used
when the value of an asset might depend more on how
much it’s been used, rather than how old it is.
– Units of production can refer to such things as tons hauled,
kilometres driven, hours used, widgets manufactured, etc.
• Units-of-production depreciation:
Pt
dt   B  S 
PLifetime
– dt = depreciation expense in year t
– B = original value of asset
– S = salvage value
– Pt = production in year t
– PLifetime = total lifetime production of the asset
Dave Ludwick, Dept. of Mech. Eng.
Depreciation
33 Summer 2008
ENGG 401 X2 – Fundamentals of Engineering Management
Units-of-Production Depreciation Problem
• You purchase a new $900 asset to be used in a sand and
gravel pit that will only be in operation for five years, after
which you expect to be able to sell it for $70. You decide to
calculate its depreciation using the units-of-production
method and expect it to be used different amounts in each
year, as follows:
Year Sand and Gravel Needed
1 4000 m3
2 8000 m3
3 16000 m3
4 8000 m3
5 4000 m3
• Calculate the asset's annual depreciation charge and its
remaining value each year.
Dave Ludwick, Dept. of Mech. Eng.
Depreciation
34 Summer 2008
ENGG 401 X2 – Fundamentals of Engineering Management
Depreciation and Taxes
• The Canadian Revenue Agency (CRA) permits a business
to claim a Capital Cost Allowance (CCA) against it’s
earnings for the period.
– CCA is the tax equivalent of depreciation
• CCA is not calculated on a per asset basis, but rather all
assets of a certain class are pooled together, and their total
residual value is called Undepreciated Capital Cost
(UCC).
– UCC is the tax equivalent of book value
• CRA has specific rules regarding the method and rate a
business can use to calculate CCA
– Declining balance depreciation is used, but the exact rate varies by
class of asset Dave Ludwick, Dept. of Mech. Eng.
Depreciation
35 Summer 2008
ENGG 401 X2 – Fundamentals of Engineering Management
Depreciation and Taxes (2)
• Tax depreciation is virtually always higher than book
depreciation.
– This means real taxes are initially lower than they would be if book
depreciation were used for tax purposes.
• The difference between depreciation for accounting
purposes and depreciation for tax purposes is called
deferred taxes.
– The difference between taxes paid according to the law and the
taxes you would have paid if taxes were based on your actual
depreciation
– Deferred taxes, like depreciation, also appear on the income
statement as a charge against income (the reduce book income)
Dave Ludwick, Dept. of Mech. Eng.
Depreciation
36 Summer 2008
ENGG 401 X2 – Fundamentals of Engineering Management
Depreciation and Taxes (3)
• Capital Cost Allowance (CCA) is the tax equivalent of
depreciation
– CCA uses the declining balance method, at various rates.
• Undepreciated Capital Cost (UCC) is the tax equivalent of
book value
– The value of all assets of a particular class are lumped together into
one UCC for each class.
• One complicating factor in depreciation for tax purposes is
the 50% rule or half-year convention.
– For most assets, a business can only claim 50% of it’s normal CCA
in the year in which it was acquired.
– The full amount is claimed in all subsequent years.
Dave Ludwick, Dept. of Mech. Eng.
Depreciation
37 Summer 2008
ENGG 401 X2 – Fundamentals of Engineering Management
Depreciation and Taxes Example
• Your company has six vehicles at UCC values listed:
1998 Chevy Van $ 22 465
2002 Hyundai $ 31 620
2000 Honda Accord $ 18 732
1980 Ford Bronco $ 2 419
1995 Dodge Pick-up $ 11 563
Total: $ 86 799
• Calculate Class 10 CCA (i.e., 30% rate) if:
– Sell Accord for $20 000 in year 2
– Buy Toyota Land Cruiser for $26 000 in year 3
– Sell Bronco for $850 and purchase computer for $25 000 in year 5
– Sell all remaining vehicles for $9 000 total in year 6
Dave Ludwick, Dept. of Mech. Eng.
Depreciation
38 Summer 2008
ENGG 401 X2 – Fundamentals of Engineering Management
More on Depreciation
• The book value of any asset is strictly non-increasing.
– In very rare cases, you can be permitted to change the rate of
depreciation.
• If inflation or something else drove the market value of an
asset up above the book value (or even it’s cost basis), you
still cannot increase its book value.
– Doesn’t matter if the book value was brought down by depreciation
or even a writedown at some past point in time
Dave Ludwick, Dept. of Mech. Eng.
Depreciation
39 Summer 2008